Navigating a Slow Market

The crickets are chirping. It feels as though multifamily transactions have ground to a halt. With the 10-year US Treasury rate around 4.5%, interest rates for new acquisitions are around 6%. And since rents are languishing in most markets, the year-one cap rate needs to be in excess of 6%—a number most owners aren’t willing to accept. Until interest rates fall, rents take off, or lenders sell foreclosed properties en masse, the multifamily market will remain muted.

What do you do if your business involves acquiring multifamily properties?

Wait.

Finding Elusive Rent Growth

Assuming you don’t want to wait, a good place to start is finding the markets where rents are growing. You’ve probably read that apartment rents in San Francisco are headed to the moon, but elsewhere in the Bay Area we’re seeing respectable 3-5% rent growth. Rents in the Midwest are increasing around 2-3%, largely keeping pace with inflation. We own in both regions, and it feels like there’s more product for sale today in the Midwest. Bid sheets are particularly deep for suburban assets with predictable cash flow. In the Bay Area, on the other hand, brokers seem to have overshot on price and some deals are sitting unsold. Markets outside San Francisco are being priced as if they’re experiencing San Francisco levels of rent growth—they’re not…yet.

Not everyone has a mandate to invest in the Midwest. Even fewer people want to take up the challenge of understanding the Bay Area. Downtime is a good excuse to learn new markets. If your mandate is the Sunbelt, research Oklahoma City or Tulsa. They’re not sexy like Austin—but then again, Austin had rent declines of 5% while Oklahoma’s increased. Or see if your investors will let you go outside your geography and explore Kansas City, Columbus, or Minneapolis—all markets seeing recent rent growth.

REO

Instead of paying a low cap rate for core or core plus deals in the Sunbelt, a more interesting game is finding REO (Real Estate Owned). Banks and other lenders aren’t in the primary business of owning property, so when they end up with it through foreclosure, it’s called REO or OREO (Other Real Estate Owned). These are often distressed properties that may need a significant cash infusion to stabilize. We’ve heard anecdotal evidence of REO in Texas markets listed for half of what non-distressed property would sell for.

If there’s enough distress at a property, it’ll be difficult to finance. Luckily, the lenders selling these assets are often willing to provide aggressive financing terms, since a higher sale price helps them recoup more of the principal balance left behind by the defaulting borrower. Financing may be based on what the property looks like at stabilization, not how it’s performing today. That’s great if you can achieve the pro forma. If not, taking on too much debt will put you in the same place as the last owner—in default. Executing on a property like this in a flat market is difficult unless you have significant cash reserves or operating expertise.

The Case For Waiting

Waiting is the hardest path because most real estate people are deal people. They like the thrill of finding a new acquisition, executing the business plan, and generating returns for investors—and thus for themselves. But while you wait, the best way to generate returns is to be a better operator than the competition. By operating well, you learn how far to push rents, which unit types can be upgraded (renovations, added bedrooms, in-unit washer/dryers, etc.), and how expensive those capital projects will be.

For example, we purchased an apartment portfolio in San Jose late last year. We haven’t bought anything since, though we want to. We now have inside knowledge of what rents can be, the costs to renovate units and repair deferred maintenance, and the time it takes to work through the City of San Jose’s planning department. We look at potential acquisitions through a new lens, which lets us get more aggressive in some areas and more conservative in others. That information comes from the day-to-day rigor of operating rather than from riding a macro wave of rent increases—though a market with tailwinds is better than one without.

Returns Today

The real issue isn’t that there aren’t any deals—there are. They just don’t provide the returns they used to for the same level of risk. A multifamily investment projected to generate a 12% IRR is a tough sell when the S&P is up 20% over the past 12 months and a slew of space- and AI-related IPOs are on deck this year. Apartment investing was never a get-rich-quick proposition. It was something you invested in to stay rich, or to get rich slowly. We’re back to those days, and the marketing pitch isn’t as zippy as the 20% Sunbelt flips of a few years ago.

So we all wait for a “story”: an investment thesis compelling enough to break through the noise, with the potential to generate outsized returns. These deals are rare by nature, and rarer still in this market.

We continue to wait.